WE NEED TO dispose of some preliminaries first. ‘Demonetisation’ means that some kind of currency unit loses its status as legal tender. This is different from a currency being withdrawn from circulation. A currency unit may be withdrawn from circulation, but can continue to remain legal tender. In America, Section 102 of the US Coinage Act of 1965 is a guarantee against any future demonetisation. ‘All coins and currencies of the United States (including Federal Reserve notes and circulating notes of Federal Reserve banks and national banking associations), regardless of when coined or issued, shall be legal tender for all debts, public and private, public charges, taxes, duties, and dues.’ It is important to make this point, since there are misinformed reports that the US ‘demonetised’ high-denomination notes in 1969. What was done was withdrawal from circulation, not demonetisation. The European Central Bank’s (ECB’s) decision on the €500 note is no different.

In the Indian case, there is legislation that allows for demonetisation. This is the High Denomination Bank Notes (Demonetisation) Act of 1978, passed in March that year, and originally enacted as an ordinance. Its Preamble indicates that it was enacted to address the issue of illicit money transfers. ‘An Act to provide in the public interest for the demonetisation of certain high denomination bank notes and for matters connected therewith or incidental thereto. Whereas the availability of high denomination bank notes facilitates the illicit transfer of money for financing transactions which are harmful to the national economy or which are for illegal purposes and it is therefore necessary in the public interest to demonetise high denomination bank notes.’ High- denomination here ‘means a bank note of the denominational value of one thousand rupees, five thousand rupees or ten thousand rupees’. Among other things, this statute prescribes a process for an individual or enterprise to surrender such bank notes to a bank. One should note that when the equivalent amount is paid to the holder in some other currency unit, this is not necessarily paid into a bank account, not under the 1978 statute. If the individual or enterprise does not have a bank account, once identity has been established, the amount can also be paid in cash.

But this doesn’t mean that demonetisation has to be necessarily done through an ordinance or statute. Consider the Reserve Bank of India Act, 1934. Section 24(2) states: ‘The Central Government may, on the recommendation of the Central Board, direct the non-issue or the discontinuance of issue of bank notes of such denominational values as it may specify in this behalf.’ Section 26(2) adds: ‘On recommendation of the Central Board the Central Government may, by notification in the Gazette of India, declare that, with effect from such date as may be specified in the notification, any series of bank notes of any denomination shall cease to be legal tender save at such office or agency of the Bank and to such extent as may be specified in the notification.’ Does this cover demonetisation or withdrawal of notes from circulation? Despite the extensive media coverage of demonetisation, I don’t think too many people have focused on this, a difference that is more than pedantic. I don’t know the answer. It can only be interpreted judicially or legally. After Rs 500 and Rs 1,000 notes have been withdrawn from circulation from the midnight of November 8th, would the RBI—not banks, mind you—still have to redeem them at face value at whatever future date, even beyond December 30th, 2016?

In 2015, the Institute for Business in the Global Context brought out a study titled, ‘The Cost of Cash in India’. This mentions that in 2012, 87 per cent of transactions in India were cash- based, even though the share of non-cash transactions has been increasing. ‘India’s cash intensity also stands out in contrast to other developing countries. The value of notes and coins in circulation as a percentage of GDP in India is 12.04%, compared to 3.93% in Brazil, 5.32% in Mexico, and 3.72% in South Africa.’ This study also highlights behavioural patterns that drive the demand for cash: ‘Most consumers see three main benefits of cash. Cash confers power on buyers, since they can offer fixed bids for a bundle of goods and services… Two-thirds of the respondents appreciate that cash assures exact payment… We also find that cash-only consumers know far less about credit cards.’ There are costs, as well as perceived benefits, associated with holding cash. Section 40A(3) of the Income Tax Act recognises this, since it disallows deductions on expenditure made in cash but only if the payment is more than Rs 20,000 per day. While a switch to non-cash payments is desirable and there can be incentives to encourage electronic payments, cash payments will not disappear instantaneously. Having said this, one must be careful in hastily citing lack of financial inclusion. As of November 9th, 2016, 255.1 million Pradhan Mantri Jan DhanYojana (PMJDY) accounts have been opened, 156.7 million in rural India. Also, 194.4 million Rupay cards have been issued. I am not discounting the problem of financial inclusion. However, with rapid changes, many more people now have bank accounts, even among the poor. It is a different matter that they don’t necessarily use those accounts, or know that debit cards can be used for transactions and not just for ATM withdrawals. Reactions like “My maid doesn’t have a bank account, my driver doesn’t have a bank account” are probably exaggerated.

There is indeed a correlation between the use of cash and the size of the informal economy. The unorganised sector can be estimated either as a share of employment or as a share of GDP.

Either way, its proportion in India is large. A 2012 Report of the National Statistical Commission on this sector stated, ‘More than 90 per cent of the workforce and about 50 per cent of the national product are accounted for by the informal economy.’ Most estimates that float around of the black economy’s share in GDP are actually estimates of the size of the informal economy in GDP, and this vital distinction is missed. Any notion of ‘black’ must have an element of illegality associated with it. This is made abundantly clear in a 2012 White Paper brought out by the Ministry of Finance on black money: ‘Black money is a term used in common parlance to refer to money that is not fully legitimate in the hands of the owner. This could be for two possible reasons. The first is that the money may have been generated through illegitimate activities not permissible under the law, like crime, drug trade, terrorism, and corruption, all of which are punishable under the legal framework of the state. The second and perhaps more likely reason is that the wealth may have been generated and accumulated by failing to pay the dues to the public exchequer in one form or other. In this case, the activities undertaken by the perpetrator could be legitimate and otherwise permissible under the law of the land but s/he has failed to report the income so generated, comply with the tax requirements, or pay the dues to the public exchequer, leading to the generation of this wealth.’ I will call the first, where the activity itself is illegal, double black. I will call the second, where the activity isn’t illegal, but taxes haven’t been paid, single black. A black economy has elements of both.

In 1978, notes of Rs 1,000, Rs 5,000 and Rs 10,000 were demonetised. What was high-denomination in 1946 or 1978 is not necessarily so in 2016, because inflation erodes the currency’s value

The White Paper also made other important points. First, the dividing line between white and black is not cast in stone. One blurs into the other. Second, there is a difference between the stock of black wealth and the creation of future black income. While a lot of attention focuses on the former, the latter is just as important, if not more. The last proper estimate of the black economy in GDP, and not the informal economy in GDP, goes back to the mid-1980s. That study by the National Institute of Public Finance and Policy (NIPFP) got a figure of around 20 per cent of GDP, far lower than the 40 per cent figure that floats around. Because of various measures, the figure today is bound to be lower than 20 per cent. The White Paper identified specific areas for reforms—taxes, the financial sector, real estate, bullion, jewellery, mining, equity trading, the cooperative sector and elections.

In 2014, the RBI withdrew some notes—on which the date of printing was not printed—from circulation. However, this wasn’t demonetisation. The first such exercise was done in January 1946, when currency notes with denominations higher than Rs 500 were demonetised. The ostensible reason then was the same as in 1978, the curbing of illicit transactions. Since high-denomination notes (of Rs 1,000, Rs 5,000 and Rs 10,000) were reintroduced in 1954, eight years later, one deduces that this 1946 experiment wasn’t terribly successful. It is sometimes suggested that the 1971 Direct Taxes Enquiry Committee (aka the Wanchoo Committee) recommended demonetisation. Its final report had nothing to say on this matter, although it did endorse the views stated in the Committee’s interim report of 1970. This report had a somewhat inconsistent view on demonetisation. It accepted that the 1946 exercise didn’t work. ‘Demonetisation was not successful then, because only a very small proportion of total notes in circulation were demonetised in 1946 and its worth was Rs. 1,235.93 crore,’ it said and then went on to recommend demonetisation.

Madhav Godbole, in his book Unfinished Innings: Recollections and Reflections of a Civil Servant (Orient Longman, 1996), has the following to say about what happened thereafter: ‘In the middle of 1971 the Direct Taxes Enquiry Committee, popularly known as the Wanchoo Committee, submitted an interim report in which, inter alia, it recommended the demonetization of high-value currency notes. As soon as the report was received, it was discussed in a series of meetings in the Finance Minister’s room. By that time Y.B. Chavan had been shifted as Finance Minister. After detailed consideration, it was decided to undertake a series of steps, including demonetization, as recommended by the committee. In view of the sensitive nature of the subject and the need for maintaining utmost secrecy, it was decided that the Finance Minister should speak to the Prime Minister and obtain her approval to the proposed course of action before further steps were initiated. Accordingly the Finance Minister spoke to the Prime Minister. As he told me on his return from the meeting, the conversation was very brief and very crisp. When Y.B. Chavan told her about the proposal for demonetization and his view that it should be accepted and implemented forthwith, she asked Chavan only one question: “Chavanji, are no more elections to be fought by the Congress Party?” Chavan got the message and the recommendation was shelved.’ In other words, anything like demonetisation requires political courage and conviction.

When Y.B. Chavan told Indira Gandhi about the proposal for demonetization and his view that it should be accepted and implemented forthwith, she asked Chavan only one question: “Chavanji, are no more elections to be fought by the Congress Party?” Chavan got the message and the recommendation was shelved

Later, in 1978, notes of Rs 1,000, Rs 5,000 and Rs 10,000 were demonetised. What was high-denomination in 1946 or 1978 is not necessarily so in 2016, because inflation erodes the currency’s value. Consequently, the Rs 500 note was re-introduced in 1987 and the Rs 1,000 note in 2001. How many notes were surrendered in 1978? They amounted to around 1 per cent of the total circulation of notes then. A different figure is more pertinent. At that time, the total value of high-denomination notes was Rs 146 crore. Of this, Rs 125 crore was surrendered to the RBI—that is, 85 per cent. We simply don’t know what happened to the remaining Rs 21 crore. Somewhat speculatively, we can state the following: For 15 per cent of those notes’ holders, their stock of black wealth was destroyed, but in the process, 85 per cent of their holders were put through some inconvenience.

The NIPFP study mentioned earlier also had specific comments on the 1978 effort. ‘The government has resorted to demonetisation of high-denomination currency notes on two occasions, once in 1946 and again in 1978. A crude index of the penal success of this measure is given by the value of high denomination notes which were not presented for conversion. By this yardstick, neither venture was a success. In 1946 only about Rs 9 crore of high denomination notes, out of a stock of Rs 144 crore in circulation, were presented for conversion. In 1978 the value of unconverted high denomination notes was Rs 20 crore out of a circulation of Rs 145 crore [note that the figures were actually Rs 21 crore and Rs 146 crore]. Quite apart from the relatively paltry results obtained on the two occasions on which it has been tried, there are other good reasons to doubt the efficacy of this measure in combating black income generation. First, the measure is limited to inflicting penalties on those who hold their black wealth in the form of cash at the moment of demonetisation. There is every reason to believe that cash is not an important form for holding black wealth… especially for those who are active participants in black income generation. So the distribution of the penalty is likely to have little correlation with the distribution of black wealth. Second, even for holders of cash, there exist avenues for converting high denomination notes into lower valued ones, at a discount, through intermediaries. Third, and perhaps most importantly, the measure does not address the underlying causes of black income generation. Hence, subsequent generation of such incomes can continue unabated with due precautions for the form in which unspent black incomes are held. The once- and-for-all penalty exacted by demonetisation simply puts everyone on their guard for the future, but does nothing to alter the incentives which spawn the black incomes. Of course, since cash is the principal vehicle for conducting black transactions, there is undoubtedly a temporary dislocation in such activities. The point is that the dislocation is temporary.’

Many people who criticise the present demonetisation do not realise that we have been down this route before and every argument being made today has been made earlier

Many people who criticise the present demonetisation do not realise that we have been down this route before and every argument being made today has been made earlier.

AT THE END of March 2016, the banknotes in circulation were worth Rs 16 lakh crore. A little over Rs 6 lakh crore was in the form of Rs 1,000 notes and almost Rs 8 lakh crore was in the form of Rs 500 notes. There has been a disproportionately high increase in cash holdings with the public, and much of that is in the form of these denominations. We don’t quite know why either has happened. The electoral cycle—including state elections—is not a convincing answer, since this cycle is almost a continuous one. It may well have something to do with the fact that both real estate and capital markets are down and therefore more cash is being held. Of course, the Rs 1,000 note that has just been phased out didn’t exist before 2001, so its share before that was non-existent. On the demand side, the increase in its usage isn’t unusual, considering the inflation since. But there is a supply side, too. In absolute terms, a higher denomination note may cost more to print, but in relative terms it’s cheaper. On an average, a smaller note also lasts for a shorter period. The smallest lasts for about a year, Rs 100 for around 3-4 years and Rs 500 or Rs 1,000 note for 5-7 years. Therefore, there are significant costs associated with moving all transactions to low-denomination notes.

Fake Indian currency notes deserve a mention. During 2015-16, by RBI-published data, 632,926 pieces of fake currency notes were detected. (The share in circulation is a function of whether one counts the number of pieces or value.) Single-shot demonetisation doesn’t solve the problem of fake and counterfeit notes in perpetuity. As in other forms of crime, this activity could go on. Technology enables better security features, but criminals also get better at it after some time. Surely, not being able to close the loop eternally isn’t a plausible argument for taking no action against fake currency. Here is a quote from a Finance Ministry press release on November 8th, 2016: ‘Fake Indian Currency Notes (FICN) in circulation in these denominations are… larger as compared to those in other denominations. For a common person, the fake notes look similar to genuine notes. Use of FICN facilitates financing of terrorism and drug trafficking. Use of high denomination notes for storage of unaccounted wealth has been evident from cash recoveries made by law enforcement agencies from time to time. High denomination notes are known to facilitate generation of black money. In this connection, it may be noted that while the total number of bank notes in circulation rose by 40% between 2011 and 2016, the increase in number of notes of Rs. 500/- denomination was 76% and for Rs.1,000/- denomination was 109% during this period. New Series bank notes of Rs.500/- and Rs. 2,000/- denominations will be introduced for circulation from 10th November, 2016. Infusion of Rs. 2,000/- bank notes will be monitored and regulated by RBI. Introduction of new series of banknotes which will be distinctly different from the current ones in terms of look, design, size and colour has been planned.’

The demonetisation of November 8th isn’t meant to address creation of new ‘black’ income. For that, the Government has already taken some measures and will take some more. On steps that have already been taken, the Finance Ministry press release has a listing: ‘In the last two years, the Government has taken a number of steps to curb the menace of black money in the economy including setting up of a Special Investigation Team (SIT); enacting a law regarding undisclosed foreign income and assets; amending the Double Taxation Avoidance Agreement between India and Mauritius and India and Cyprus; reaching an understanding with Switzerland for getting information on Bank accounts held by Indians with HSBC; encouraging the use of non-cash and digital payments; amending the Benami Transactions Act; and implementing the Income Declaration Scheme 2016.’

In the world of Physics, there is no unified field theory. I wonder why people look for one when the question of black income arises. The Government didn’t claim that. The action of November 8th was meant to address the present stock of it, not its fresh creation.

It is only one of various steps, not the only one, and it isn’t meant to resolve all ‘black’ problems under the sun. The stock of ‘black’ wealth isn’t necessarily in the form of cash. It can be in the form of gold, real estate and other property. That kind of non-cash ‘black’ will also be addressed through other measures. As for the stock of ‘black money’ in cash that has become invalid, my guess is as good as yours. Perhaps around Rs 5 lakh crore of those notes is ‘black’ in both the senses combined. The remaining Rs 9 lakh crore is legal cash. Of this, perhaps Rs 7 lakh crore is cash in active use for transactions. When notes are demonetised, this gets drawn out of the system and is replaced by new notes. Sure, this inconveniences people. But as citizens, are we prepared to tolerate this inconvenience, or are we saying we want the Government to do nothing about the Rs 5 lakh crore? Action against that money is also an additional deterrent against the creation of new ‘black’ income.

Also, Rs 2 lakh crore was with people, serving no useful purpose and not even earning a return for its holders. This sum now enters the banking system. Banks have more liquidity. The Government could obtain money through the RBI that can be used for public expenditure schemes. In that sense, there can be a transfer of wealth from the relatively rich to the relatively poor. Of the Rs 5 lakh crore that is ‘black’, around Rs 3 lakh crore is perhaps so in the sense of taxes not having been paid, while Rs 2 lakh crore is double black. (Around Rs 1.25 lakh crore of ‘black’ money had already come into the system before November 8th.) For both varieties of ‘black’, there are reports of the old-for-new exchange facility being misused by cash hoarders, through touts. I am told the going rate is Rs 350 for every Rs 1,000 tendered. Alternatively, there are reports of gold being bought at a premium. In either event, there is some destruction of value (even if not 100 per cent) suffered by those with ill-gotten cash.

There remains the question of managing the transition. In this process, printing notes is the easier part. These wads of currency have to be taken to banks and then to ATMs. The more one prepares for such a transition, the greater the danger of its news leaking out and defeating the purpose of demonetisation. Since the Finance Ministry and RBI have tweaked the rules, the Government has been accused of not having had a plan and not being prepared. I don’t quite see it in that light. Accepting feedback and modifying rules is a sign of being amenable to constructive inputs and is preferable to perverse rigidity. As of now, we are still in a period of transition, with crowds now easing off at bank branches. Calibrating ATMs will take longer. There has certainly been a short-term shock, concentrated in the third quarter of fiscal 2016-17. The gains will be in the medium term.